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Saturday, November 30, 2013

"The market continues to rise solely on the perception that the Fed’s easy money policy can hold stock prices up indefinitely.We think that this line of thinking will prove to be no more durable than the dot-com bubble that peaked in early 2000 or the housing bubble that topped out in late 2007.In both cases the market gave back a large proportion of the gains made during the bull market, and we believe that will prove to be the case this time as well.When the vast majority of investors faithfully believe in a bubble, momentum takes over and the market goes up because it’s going up, ignoring all of the obvious warnings such as high valuations, over bullishness, decreasing earnings momentum and an underperforming economy.When reality suddenly sets in, as it inevitably does, most investors are left holding the bag, hoping that the market doesn’t go any lower."

- Comstock Partners Investor Newsletter

November 2013

"The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak."

- John Hussman Investor Newsletter

November 2013

The chart below is one you may have seen before - showing the correlation between Quantitative Easing and the rising stock market. It implies that QE controls how high the market will rise and keep it from falling in the future. The Fed, we are told to believe, has created a true "invisible hand."

Before discussing the chart, I want to review how Quantitative Easing works and why it has been very bullish for the stock market during this cyclical recovery.

The Fed purchases $85 billion per month in treasury and mortgage bonds. The Fed prints money electronically and purchases these bonds from a primary dealer (one of the large banks). The banks hand the Fed the bonds in exchange for the cash. The actual process occurs through numbers changing on a computer screen electronically.

The accumulation of these bonds on the Fed's balance sheet creates the growth in the green line seen in the chart above. This process drives down the interest rates on treasury and mortgage bonds (simultaneously driving their prices higher because lower rates = higher bond prices). The Fed is now purchasing close to 100% of the new issuance of both treasuries and mortgage bonds.

The second part of this process is discussed less often...what the primary dealers do with this large stockpile of cash.

In normal times (pre-2008), the banks would use this cash as reserves to lend out into the economy. They would lend money on cars, homes, commercial real estate, small businesses or credit cards. This process stimulated economic growth.

The large banks only need to keep 10% of their cash on the books as required reserves. This means if the Fed were to hand them $10 billion in new cash through quantitative easing, they would then be able to lend out $100 billion into the real economy. The additional $90 billion of new money to be lent is created out of thin air. For example, when you open a credit card line and begin swiping your card at the stores, you are swiping that money into existence each time you make a purchase. As your card hits the machine, the large banks see it simultaneously appear on their screens as an asset. The same process occurs for mortgages, auto loans, etc. For more on how this process works I would suggest watching this brief video on Modern Money Mechanics.

Since the 2008 financial crisis, we have not lived in normal times. As the banks have received cash from the Federal Reserve, they have not lent it out into the economy. They have taken the cash and immediately redeposited it with the Federal Reserve earning 0.25% interest on their money. It is essentially a way for them to earn a return on the money with zero risk.

The Fed currently holds $77 billion in "required" reserves. All the money above the $77 billion is considered "excess" reserves because the banks are not required to keep it there. Before 2008, the banks held no excess reserves with the Fed. Since 2008 the excess reserves have grown to $2.3 trillion.

This $2.3 trillion creates a conundrum for the Federal Reserve. On one hand, they would like to see that money lent into the economy because it would stimulate growth. On the other hand, that $2.3 trillion could be lent out at 10 times that amount, which would create an enormous amount of inflation. Instead, it is sitting dormant on the Fed's balance sheet quietly earning interest. This is why the QE programs have not created inflation that has shown up heavily in the consumer price index. The velocity of money, or how quickly it is lent and re-lent into the economy, is stalled.

Let's now review how this money has impacted the stock market.

Imagine that you lent your neighbor $100,000 to purchase his home. In exchange, he gives you a mortgage note promising to pay the money back with interest. The Federal Reserve gives you a call one afternoon and tells you they would like to purchase that note and they will give you $100,000 in cash. You agree, and they show up at your front door and hand you a suitcase full of money. You hand them the mortgage note and all payments from your neighbor will now go to the Fed.

Now you are sitting with $100,000 on your kitchen table so you think about how you could invest it. You give your mortgage broker a call. The broker tells you that you can open up something called a margin account. If you take that $100,000 back down the street and deposit it with the Federal Reserve you can then use that money to buy stocks. "Excellent." you say. The money is then deposited with the Fed and you go into the market and begin to purchase stocks. Your broker knows that if you run into losses, you will have access to the reserves at the Fed to cover.

This is what the large banks have done. Instead of lending the money out into the economy and trusting American consumers and businesses to pay it back, they are handing the money to their professional traders and letting them put the money to work in the financial markets. This has paid off handsomely for the banks. They earn interest on the money at the Fed AND they earn trading profits off their margin accounts as they gamble in the financial markets.

The problem is that the QE process has become a closed loop. None of the money makes its way into the real economy. The only people that benefit are the ones that already own the particular asset that the banks decide to purchase (which has been dominantly US stocks). The rest of America suffers. This divergence can be seen in the sales and stock prices of high end retailers (who have high net worth buyers benefiting from the Fed's QE programs) and the lower end buyers.

That brings us to where we are today and sums up the non-existent economic recovery seen over the last 5 years. It also explains why people are confused at why stock prices are surging while the real economy stagnates.

The assumption that has been baked into the markets is that the chart we began with will always move higher in perfect correlation: the rise in stock prices will be determined by the size of the QE program. This assumption, is false, and will soon be devastating for those that now believe it.

Why?

The banks are not limited to purchasing U.S. stocks. The chart above showing the rise in the Fed's asset prices with rising U.S. stock prices is a coincidence not causation. The primary dealers can wake up tomorrow morning and decide that they would like to start purchasing REITs in Brazil, Asian water companies or mines in South Africa. They will ride this U.S. equity rally for as long as possible and when the music stops, I assure you they will be the first out the door.

If the U.S. stock market began falling while the Fed was still conducting QE, the misplaced belief in the Fed's "power" to control the markets would be removed. They have already begun to lose control of the bond market. People will look back years from now and marvel at how ridiculous it was to think that the Fed has the magical powers they are believed to hold today.

“For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.”

As bitcoin has not stopped to catch its breath and just a few days later has soared through $1,240, we can look at some fun charts comparing it to the South Sea bubble of 1720. For those unfamiliar with the South Sea bubble, Wikipedia provides a good summary.

The following charts come from Mebane Faber, layering the bitcoin price (blue line) against the South Sea Company (red line) hundreds of years ago.

You'll notice that because the chart is more than a few hours old it has bitcoin at $900. The price is moving higher at such an exponentially parabolic rate it makes charts like these dated quickly. You can visualize the blue line above blasting $340 higher (making it that much more absurd).

What followed next for the South Sea company (red line in the chart below) was the same experience seen in the Tulip Bulb mania and Mississippi bubble. A complete collapse.

Last night the price of bitcoin hit a historic point when one bitcoin exceeded the price of one ounce of gold.

Bitcoin will be held up by historians in the same regard as the famous bubbles discussed above. It is a true testament that while the world surrounding us can change dramatically over hundreds of years, human psychology and the subsequent madness of crowds will always be with us.

Tuesday, November 26, 2013

While both the media and buyers of paper asset prices at these "frothy" levels are 100% confident that there will be no negative consequences from the Fed either removing their stimulus or just letting QE run forever, there are a select few people around the world who still pause for concern. After injecting the QE drug for 5 solid years combined with 0% interest rates, it begins to feel like a zombie movie as more and more people around you are infected with the disease.

I have discussed this topic from every possible angle, but reviewing it again is important because every day the madness builds around us making it more difficult to stay focused on what is really happening.

Since the taper off announcement back in September it has been full throttle forward on risk paper assets. The stock market is a one way rocket ship higher with every index hitting new highs on the hour. The 10 year treasury market has backed far away from the dangerous 3% level. Corporate bonds, specifically the high yield (junk) bonds, are now back at the mania yields seen earlier this year.

Concern about defaults, however, is most keenly felt at the more speculative end of the market, called high-yield, where issuance is at $414 billion so far.

"At the moment they are buying at low-yield levels they are being handsomely compensated for default risk because there will be hardly any defaults in the next two years," said Hans Stoter, chief investment officer at ING Investment Management, which manages $238 billion.

"But if we move to the next default cycle, which is, I think, two to three years away, and people really get worried about getting their money back and they want to exit their positions, then we are going to be in a full room heading for the exit door and the door will turn out to be a very small one."

As home prices surge higher in some markets, buyers are once again taking out home equity lines to upgrade their homes. In an article from Bloomberg titled "Faucets at $1,000 Abound As Home Equity Spigot Opens," we learn that home owners are no longer happy with their granite counter tops, they must upgrade to marble.

The QE drug has been with us for so long that it is now accepted as permanent. The longer people live in this artificial world the more they believe it will stay, and they begin to make all decisions around this new reality. This is why so many people are hurt so badly once this process is reversed and the curtain is pulled back to show that there is no fundamental economic recovery, only a heroine induced high.

The four largest areas of concern for the reversal of QE are:

1. The reversal of risk asset prices (we saw a preview of this in June). All the benefits of asset prices rising are immediately turned into negative consequences on the way down. The problem is that on the way up investors borrow money (leverage) to take maximum advantage of the new "permanent" rise in assets. This leverage creates a waterfall cascade of selling on the way down.

2. Rising treasury prices will send the annual interest on the national debt much higher. If rates normalize (back to the average treasury yield seen just over the last 20 years) then the annual cost to carry the current $17 plus trillion in federal government debt would be well over $500 billion annually. That is just interest, it does not include the money needed to roll over existing debt as it matures and the annual deficit needed to fund government spending. As rates rise further and debt continues to mount, you begin to enter the Greece like end game spiral.

3. Rising treasury prices will reprice corporate bonds, state and local government debt and mortgage bonds. You could write an entire book on the consequences of that last sentence. Rising mortgage yields will crush both the housing and commercial real estate market.

4. The Fed itself will become insolvent. The Fed's balance sheet is now composed of long term treasury and mortgage bonds. They are leveraged at 57 to 1 on this debt. Should rates rise slightly these assets move underwater and in order to stay solvent by accounting standards they would need to begin borrowing money from the treasury to cover the difference. This would come at a time when the government would need money the most (see 2 above). I talked about this topic in detail in: Why The Fed Can Never Exit

The following from Peter Schiff at Euro Pacific Capital provides a summary on where we are with QE and what happens next.

Herd mentality can be as frustrating as it is inexplicable. Once a crowd starts moving, momentum can be all that matters and clear signs and warnings are often totally ignored. Financial markets are currently following this pattern with respect to the unshakable belief that the Federal Reserve is ready, willing, and most importantly, able, to immediately execute a wind down of its quantitative easing program. Although the release last week of the minutes of the Fed’s last policy meeting did not contain a shred of hard information about the certainty or timing of a "tapering" campaign, most observers read into it definitive proof that the Fed would jump into action by December or March at the latest. The herd is blissfully unaware that the Fed may not be able to reverse, or even slow, the course of QE without immediately sending the economy back into recession.

In an interview this week, outgoing Fed Chairman Ben Bernanke likened the QE program to the first stage in a multiple stage rocket that gets the spacecraft off the ground and accelerates it to the point where it is close to achieving permanent orbit. Like a first stage that has spent its fuel and has become dead weight, Bernanke seems to concede that QE is no longer capable of providing positive thrust, and as a result can now be jettisoned (like a first stage) so that the remainder of the spacecraft/economy can now move higher and faster. The Chairman's nifty metaphor provides some inspiring visuals, but is completely flawed in just about every way imaginable.

In real rocketry, when the first stage separates, it falls back to earth and is no longer a burden to the remainder of the ship. Subsequent booster rockets (which in economic terms Bernanke imagines would be continuation of zero interest rate policies) build on the gains made by the first stage. But the almost $4 trillion in assets that the Fed has accumulated as a result of the QE program will not simply vaporize into the stratosphere like a discarded rocket engine. In fact it will remain tethered to the rest of the economy with chains of solid lead.

In the process of accumulating the world's largest cache of Treasuries, the Fed has become the most important player in that market. I believe the Fed can't stop accumulating and dispose of its inventory without creating major market disruptions that will drag the economy down.

This would be true even if the economic rocket were actually approaching escape velocity. In reality, we are still sitting on the launch pad. By keeping interest rates far below market levels and by channeling newly created dollars directly into the financial markets, the QE program has resulted in major gains in the stock, real estate, and bond markets. Many have argued that all three are currently in bubble territory. Yet to the casual observer, these gains are proof of America's surging economic vitality.

But things look very different on Main Street, where the employment picture has not kept pace with the rising prices of financial assets. The work force participation rate continues to shrink (recently falling back to levels last seen in 1978),real wages have declined, and since the end of 2009 the temporary workforce has grown at a pace that is 14 times faster than those with permanent jobs. Americans are driving less, vacationing less, and switching to lower quality products and services in order to deal with falling purchasing power. But the herd is closely watching the Fed's rocket show and does not understand that stocks and housing will likely fall, and bond yields rise steeply, once the QE is removed. The crowd is similarly ignoring the significance of the Chinese announcement.

But while the Fed was gaining much attention by saying nothing, the Chinese made a blockbuster statement that was summarily ignored. Last week, a deputy governor of the People's Bank of China said that buying foreign exchange reserves was now no longer in China's national interest. The implication that China may no longer be accumulating U.S. government debt would amount to the "mother of all tapers" and could create a clear and present danger to the American economy. But the story barely rated a mention in the American media. Over the past decade or so, the People's Bank of China has been one of the largest buyers of U.S. Treasuries (after various U.S. government entities that are essentially nationalizing U.S. debt). China currently sits on $1 trillion or more in U.S. bond obligations.

So, just as many expect that the #1 buyer of Treasuries (the Fed) will soon begin paring back its purchases, the top foreign holder may cease buying, thereby opening a second front in the taper campaign. This should cause any level-headed observer to conclude that the market for such bonds will fall dramatically, causing severe upward pressure on interest rates. But the possibility is not widely discussed.

Also left out of the discussion is the degree to which remaining private demand for Treasuries is a function of the Fed's backstop (the Greenspan put, renewed by Bernanke, and expected to be maintained by Yellen). The ultra-low yields currently offered by long-term Treasuries are only acceptable to investors so long as the Fed removes the risk of significant price declines. If the private buyers, the Fed, China (and other central banks that may likely follow China's lead) refuse to buy Treasuries, who will take on the slack? Absent the Fed's backstop, prices will likely have to fall considerably to offer an acceptable risk/reward dynamic to investors. The problem is that any yield high enough to satisfy investors may be too high for the government or the economy to afford.

Little thought seems to be given to how the economy would react to 5% yields on 10 year Treasuries (a modest number in historical standards). The herd assumes that our stronger economy could handle such levels. In reality, 5% rates would likely deeply impact the financial sector, prick the bubbles in housing and stocks, blow a hole in the federal budget, and cause sizable losses in the value of the Fed's bond holdings. These developments would require the Fed to devise a rocket with even more power than the one it is now thinking of discarding.

That is why when it comes to tapering, the Fed is all bark and no bite. In fact, toward the end of last week, Dennis Lockhart, President of the Federal Reserve Bank of Atlanta, said that the Fed "won't taper its bond-buying until the economy is ready." He must know that the economy will never be ready. It's like a drug addict claiming that he'll stop using when he no longer needs them to stay high.

But the market understands none of this. Instead it is operating under dangerous delusions that are creating sky-high valuations for the latest social media craze, undermining the investment case for gold and other inflation hedges, and encouraging people to ignore growing risks that are hiding in plain sight.

This is not unusual in market history. When the spell is finally broken and markets wake up to reality, we will scratch our heads and wonder how we could ever have been so misguided.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.